A New Way for Income Investors to Get Ahead

July 17th, 2011
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options-doorsMoney Morning Investing Article of the Week
by Larry D. Spears, Contributing Writer, Money Morning
A New Way for Income Investors to Get Ahead

The market isn't an easy place for income investors right now.  Stocks are too volatile, U.S. Treasury yields are anemic, and a strong reliable dividend is a rarity.

But income investors have a relatively new way they can use options to collect solid payouts on a routine basis. And they can do it without actually owning the underlying stock.  I'm talking about Weekly Options, or Weeklys.

Follow up:

Weeklys, which have a maximum lifespan of just seven trading days, are available on more than 40 widely traded stocks and a handful of indexes - including the Standard & Poor's 500 Index.

The great thing about Weeklys is that you can take advantage of short-term moves in the price of a stock or index. You can also generate income on a weekly basis by implementing a simple covered-call strategy.

Weekly Options Strategy #1: A Covered-Call Alternative

The first method is a slight variation on the standard covered-call strategy, where you own the underlying stock and write options against it for income.

Here's an example.

Assume you own 300 shares of Suncor Energy Inc. (NYSE: SU), recent price $40.10. Suncor is widely held, but unlike many oil-and-gas exploration and production companies, isn't overly volatile. Its 52-week range is $29.15 to $48.53. The dividend also isn't that spectacular at 45 cents, or 1.12%.

Let's say you believe Suncor's stock price will rise later in the year, especially if oil prices continue to rebound from their $23-plus slide between late April and late June. You don't want to sell your shares at current prices - but you would like a little extra income from the position while you're waiting for a price climb.

You would simply wait until the new "July Week 1" options were listed on Thursday, July 14. Then, sell a Suncor call option with a $41.00 strike price that expires on Friday, July 22, just eight days later.

Based on prices for the same time frame in June, that call would probably be priced around 55 to 60 cents, or $55 to $60 for each full contract. Since you own 300 shares of Suncor stock, let's assume you sell three of the calls at 58 cents a share, bringing in $174 - a play that has three distinct advantages over the standard covered-call scenario:

  • First, Suncor only has to stay below $41 a share for seven trading days - not five weeks - for you to keep 100% of the premium received. That's a 1.44% return on the $12,030 value of the stock in just over a week.

  • Second, you can repeat the play two, or possibly even three, times before the standard option would expire. If you get $174 on each weekly play, doing it three times would bring in $522 as compared to the $381 you'd get on the monthly covered-call play - increasing your five-week return to 4.33%. And, doing it four times would likely boost your monthly income to almost $700.

  • Third, you're not stuck with the same position for a full month. If Suncor's stock price rises or falls, you can adjust the strike price of the call you sell upward or downward, keeping it an appropriate distance above the actual stock price. This will tend to keep the premium you receive about the same, and maintain your cushion against an upward price spike that could force you to sell the stock.

All in all, it's a much more attractive play than the standard covered-call scenario. Indeed, the only real drawback is that, at present, Weeklys are offered on just 41 individual stocks.

But if you don't own any of the stocks on the weekly options list, and you don't have the money to buy 200 or 300 shares of some of the ones that are - say Amazon.com Inc. (Nasdaq: AMZN), recent price $210.38, or International Business Machines Corp. (NYSE: IBM), recent price $174.23 - don't fret. You can use still Weeklys to generate income without actually owning the underlying stocks.

Weekly Options Strategy #2: Low-Risk Call Selling

Sticking with Suncor, let's say you still expected the stock price to rise later in the year, but weren't quite ready to lay out $12,030 to buy 300 shares at the midday July 13 price of $40.10. You obviously can't collect the dividend without buying the stock - but you can still generate an income stream from it.

Start by going out to the September expiration month and buying three in-the-money (or at-the-money) Suncor call options. In this case, a good choice would be the September 39 strike price calls, $1.10 in the money (i.e., $1.10 below the current stock price of $40.10), priced on July 13 at $2.95 a share, or $295 per contract. That means three calls would cost $885 - a significant savings over the $12,030 value of the shares themselves.

With that as your base "long" position, you can then begin repeatedly selling out-of-the-money weekly Suncor calls, most likely bringing in a premium of $150 to $170 on each trade, depending on the position of the stock price relative to the strike price of the calls you sell. As long as the term is shorter and the strike price higher than $39.00, the weekly options you sell (for both August and the first two weeks of September) will always be "covered" by your long September monthly calls, meaning you won't have to put up any added money (or "margin").

After four or five weekly trades, you'll have offset the premium you paid for the September calls (which should still retain a good chunk of time value anyway). This leaves you another three or four weeks to sell additional Weeklys and collect income from the strategy before you either sell the September calls or exercise them to purchase the stock at $39.00 a share.

The only real potential for loss comes if Suncor's stock price falls sharply, which would carry the September 39 calls well out of the money. At that point, the shorter-term calls they'd cover wouldn't have enough premium to make them worth selling - though you could always "roll" the long position down to a lower strike price or a more distant expiration date and keep selling calls against it.

Plus, the loss on the options would most likely be less than the loss you'd have suffered had you held the stock itself - and the pullback would give you an opportunity to buy the shares at a much better price than was available when you first implemented the strategy.

The Weeklys have a number of other uses - ranging from speculating on news events such as earnings releases to hedging against possible short-term pullbacks by the broad market.

However, for income-oriented investors, the primary value of weekly options will unquestionably lie in generating a stream of steady cash flow from long stock positions.

Editor's note: GEI Investing will be posting a selected article on investing each week, hereafter on Monday, from the previous week posts at the Investing News, Analysis and Commentary website Money Morning.

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